To F*** Up The Economy or Inflation?

Email agenda:

Estimated read time: 6 minutes 10 seconds

1. Why You're Not Bearish Enough

2. Are Valuation's and Price Target's Pure Nonsense?

Good morning and happy Monday - let's get smarter

Why You're Not Bearish Enough

2 weeks ago, I went to a Rangers hockey game with a few work colleagues

At one point, one of the guys mentioned how the markets had really rebounded the past week “thankfully”

I think there is a misconception that in a bear market, the market will only go down

That there won’t be green days or weeks that you miss by being long the US Dollar and in cash rather than in meme stocks

But if you take a step back and look at the bigger picture, 3 months, or 6 months, if you understand the underlying market dynamics of the next few quarters, you won’t have FOMO on those green days or weeks

You hopefully have avoided the 20+% drawdowns of the past 6-12 months from market high’s, and you’ll also avoid the next major moves down

Here’s why

The federal reserve (“The Fed”) is in an extremely tough situation

US GDP is slowing consecutive quarters (bad) along with almost 80% of the world (recession)

US Corporation’s have profits slowing simultaneously

Inflation is at 8.2% and the fed would like to raise interest rates to get it down to 2%

A basic math equation can sum up the current state of the economy:

Raising interest rates -> slows borrowing -> which slows GDP growth -> which slows corporate profits = markets collapse

BUT

Raising rates is the only way to combat inflation

So the Fed may get into a situation where market’s are down another 10+% but they still aren’t at their target inflation of 2%

Something similar happened during the Great Financial Crisis where the Fed had to stop raising rates to intervene in the market collapse and during that time of intervention and pivoting from raising rates, the S&P 500 fell ANOTHER 48%

Discussing the market dynamics here isn’t fear mongering or being a perma-bear

It’s about being realistic about what the data says and proactively preparing by selling risk assets, raising cash, and not having FOMO when the Russell is up 2% 1 week

Yes - being bearish gets tiring and I cannot wait for the day where I am buying YOLO call options on bankrupt meme stocks like AVIS

But now is not the time for that and it's also not the time to do nothing

Here are some other bearish data points:

Are Valuation's and Price Target's Pure Nonsense?

The answer is, kind of sort of, yes

Valuations, or the enterprise value of a company (value of the core operating business), especially in startups, where there isn't much value now but you project 10 years out, can be a load of steaming shit

The main reason founders and investors raising capital want to try and justify a crazy high valuation?

Dilution

Dilution 101

If a founder own's 100% of his company, raises $1m at a $10m valuation, they are giving away 10% of their company

If that same founder can justify a $100m valuation, they are giving away 1% of their company

A 9% difference if the company sells for $500m is $45m....

Typically, like in real estate, you look at comparable companies or "comps" to help determine your valuation or valuation multiple

If your competitor trades at 10x 2023 projected revenue, you may be able to get investors to investor at 10x your 2023 projected revenue

But in reality, your valuation can be whatever you want it to be or whatever investors are willing to invest at, or a buyer is willing to buy at

The market can determine (by investing or not) if your valuation is bananas or not

Let me give you some examples

Startup Capital Raise

A startup with $0 in revenue can raise a new funding round at a $10m valuation

How is that possible?

Future cash flows: Investors care about the future cash flows of the business, and believe that if you look out into the future and this company achieves PMF (product-market-fit), that they may generate substantial cash flows that make it worth $100m

So if they invest $1m at a $10m valuation and it is eventually worth $100m, they 10x their investment

The problem: Often times, companies can raise capital in a funding round at a valuation and if they were to actually sell the business, they'd sell for A LOT LESS aka, a much lower valuation

This makes their "valuation", partially just a vanity metric

Personal example

A biologics company asked me to consult them on their capital raise

The biologics company is raising capital at a $100m valuation

Their current revenues are around $1m

So, how could I justify and defend their $100m valuation?

Business Model

Their products have a 90% gross margin (sales - cost of goods)

They have high operating leverage (% of fixed costs to variable costs)

Operating leverage isn't talked about enough

Operating leverage looks at what % of your costs are fixed and will not increase as sales/volume of sales goes up (higher operative leverage = good)

The opposite would high % of variable to fixed costs which will scale with each sale (low operating leverage = bad)

Basic English: For every incremental $ of sales price, almost ALL of it turns to profit

So this company has amazing margins, high operative leverage, and just landed 2 sales people who's book of business is about $1m a month

We made projections that showed that as we scale sales people or their book of business, we can very quickly start making $20-30m a year in EBITDA (core cash flows)

Comps

When I look at other biologics company's, they all lose a bunch of money, and have crazy high valuations

We are lean and plan to be profitable, so that makes us more valuable

So while there are A LOT of assumptions and valuation based off projections, we can defend it because we are using data to justify it

Wall Street Price Targets

A common misconception about Wall Street or just large financial firms in general is "well, they are Wall St, they know what they are doing more than anyone"

Hopefully by now, you realize more often than not, they don't

Most hedge funds don't beat the market

Let's take this Wall St analysts price targets on Carvana

In MARCH of 2022, Carvana was "LIKE TESLA" and should trade a $360 per share!

And by November of 2022, the same analyst says it should be worth.....$1!!

Clown

Valuations aren't stock price catalysts. You won't see a massive movement up because of a valuation

Valuations are HEAVILY based on assumptions that are very hard to get right

If you invest in a startup or get a private company deal, if their pitch deck doesn't have valuation comps, don't be afraid to ask them how they came up with their valuation

If they can't answer, well then my friend, that valuation was pulled out of.......

Their ass

- Dev

DISCLAIMER: None of this is financial advice. This newsletter is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any financial decisions. Please be careful and do your own research.